Don’t overdo fiscal correction

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SummaryPolitical paralysis and excessive debt in the rich world spells a gloomy outlook for the global economy.

Political paralysis and excessive debt in the rich world spells a gloomy outlook for the global economy. Overall, the world output is expected to grow by only 3.3% in 2012, compared to 5.1% in 2010. According to the IMF, the inability of the eurozone to integrate further its fiscal and monetary aspects has decreased the confidence of the bond market in sovereign debt of peripheral eurozone economies like Spain and Italy, resulting in a spike in their bond yields. Meanwhile, the polarised politics of Washington, with both Republicans and Democrats unable to reach a compromise, has deferred the outcome of any long-term plan to address the American “fiscal cliff”. This has, amongst other things, instilled doubts in the private sector and contributed to lagging American output and employment growth.

The economic growth in the mostly bouyant emerging markets is expected to, as the IMF notes, hit a “soft landing”, especially for those reliant on foreign demand. The projected growth rates for both India and China are 7.8% and 4.9%, respectively—much lower than the double digit growth of 2 years ago. Besides, a weakened demand in the rich world, bad bank balance sheets (e.g. bad loans in China) and a variety of domestic causes (e.g. infrastructure/ reforms in India) are contributing to the soft-landing.

Also, a series of historical case studies by the IMF suggests some forecasts and remedies for those currently blighted. For instance, the United Kingdom on the gold standard (1918-1938) bears similarity to the troubled peripheral eurozone economies, in that it exhibited an inflexible monetary policy coupled with a determined fiscal retrenchment. The fiscal and monetary retrenchment was able to control inflation, but real GDP barely grew over the 20-year period. This may not bear well for Europe.

What should be done to alleviate the gloomy economic scenario? IMF suggests political statesmanship in Washington and Europe can result in a bipartisan solution to the US’s debt problem, and lead to further integration and cooperation between European leaders. More importantly, this shall remove the uncertainty about future fiscal policies, which prevents businesses from planning for the future. Overall, the global economy exhibits unsustainable trade imbalances that need to be normalised. ‘Chimerica’ needs to end. Those with excessive current account surpluses, like China, must increase domestic demand to reduce savings and investment, while those showing significant current account deficits should focus more on exports.

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